Option Spread Strategies
Options are time limited contracts that trade based on the value of an underlying security, typically a stock or ETF (Exchange-Traded Fund) share price. An individual security will have a wide range of option contracts with different terms. Trading strategies, including spread strategies, use a combination of different options on the same stock to set up a profit if the underling stock moves in the predicted direction.
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Option Basics
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Option contracts come in two types. A call option gives the option holder the right to buy the underlying stock at a set price called the strike price. Call options increase in value if the stock goes up. Put options give the right to sell the underlying security at a set strike price. Put holders profit when the stock declines. Option contracts can also be sold to collect the premium or cost of the contracts. All options have a specified expiration date. Spreads strategies involve both the buying and selling of option contracts with different specifications. Spreads reduce the cost of taking a position on the potential move of a stock when compared to just buying calls or puts. Options are for 100 shares of the underlying stock and the cost is 100 times the quoted price.
Bull Call Spread
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A bull call spread is set up by buying call options with a selected strike price and selling an equal number of calls with the same expiration date and a higher strike price. The trades goes on as a debit to the traders account. The maximum profit is the difference between the strike prices less the cost of the trade. The max loss is the cost to enter the strategy. For example, the iShares Emerging Market Index Fund, symbol EEM, is trading for $46.73 per share. The April 46 call option is $2.42 and the April 50 call is $0.62. A bull call spread for one contract would cost $242 minus $62 equals $180 plus commissions. Max profit, if EEM moves above the $50 strike price, is the $400 strike difference minus the $180 cost equals $220.
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Bull Put Spread
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A bull put spread is established for a credit rather than a debit, making the strategy attractive to some traders. A bull spread is established by selling put contracts at one strike price and buying the same number of puts with a lower strike price. The bought contracts will be less expensive, resulting in a net credit to the traders account. The maximum profit is achieved if the underlying stock is above the higher strike price. Maximum loss is the difference in the strike prices minus the credit received.
Bear Call Spread
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Bear spreads profit if the underlying stock declines in value. A bear call spread is a credit spread. The spread is established by selling call contracts at one strike price and buying calls at a lower strike price. Maximum profit is achieved if the stock price drops below the lower strike price. The max profit is the credit received when establishing the trade and the maximum loss is the difference in strike prices minus the credit.
Bear Put Spread
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A bear put spread is established by selling put contracts at one strike price and buying puts at a lower strike price. This strategy is initiated at a debit to the trader's account. Maximum profit is if the stock goes below the lower strike price and is the difference between the strike prices minus the debit paid. The maximum loss is the debit paid to set up the bear put spread.
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